CreditMetrics

CreditMetrics
Methodology for measuring credit risk in
a portfolio context.
Datasets of default probabilities, recovery rates,
credit migration likelihoods and correlations.
Software system to calculate and report credit risk
for a portfolio of positions.
 Key features of CreditMetrics
It is based on credit migration analysis, i.e. the probability of moving
from one credit quality to another within a given horizon.

It models the full forward distribution of the values of any bond or

loan portfolio, where the changes in values are related to credit
migration only, while interest rates are assumed to evolve in a
deterministic fashion (limitation: assuming no market risk).

Credit-VaR of a portfolio is derived as the percentile of the

distribution corresponding to the desired confidence level.
 Challenging difficulties
in Credit-VaR
The portfolio distribution is far from being normal
(actually it is highly skewed and fat-tailed).

The correlations in credit quality changes for all

pairs of obligors are not directly observable. The
evaluation is based on the joint probability of asset
returns.
 Credit-VaR for a bond
1. Specify a rating system

Rating categories, combined with the probabilities of migrating

from one credit quality to another over the credit risk horizon.
(For example, Moodys or S&Ps or a proprietary rating system
internal to the bank.)
Assumption: all issuers are credit-homogeneous within the same
rating class.

2. Specify the forward discount curve at the risk horizon(s) for each
credit category, and the recovery rate.

Translate the above information into the forward distribution of the

changes in portfolio value consecutive to credit migration.
 Specification of
the transition matrix
The transition probabilities are based on more than 20 years of
history of firms across all industries.

Actual transition and default probabilities vary quite substantially

over the years, depending whether the economy is in recession, or
in expansion.

Many banks prefer to rely on their own statistics which relate more
closely to the composition of their loan and bond portfolios. They
may have to adjust historical values to be consistent with ones
assessment of current environment.
 Investment grade ratings
S & P and others Moody's Interpretation

AAA Aaa Highest quality; Extremely Strong

AA+ Aa1 High quality

AA Aa2
AA- Aa3

A+ A1 Strong payment capacity

A A2
A- A3

BBB+ Baa1 Adequate payment capacity

BBB Baa2
BBB- Baa3
 Speculative grade ratings
S & P and others Moody's Interpretation

BB+ Ba1 Likely to fulfill obligations;

BB Ba2 Ongoing uncertainty
BB- Ba3

B+ B1 High risk obligations

B B2
B- B3
CCC+ Caa1 Current vulnerability to default
CCC Caa2
CCC- Caa3
CC

C Ca In bankruptcy or default, or other

D market shortcomings
Transition matrix, probabilities of credit
rating migrating from one rating quality to
another, within one year.
Initial Rating at year-end (%)
Rating AAA AA A BBB BB B CCC Default
AAA 90.81 8.33 0.68 0.06 0.12 0 0 0
AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0
A 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06
BBB 0.02 0.33 5.95 86.93 5.30 1.17 1.12 0.18
BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06
B 0 0.11 0.24 0.43 6.48 83.46 4.07 5.20
CCC 0.22 0 0.22 1.30 2.38 11.24 64.86 19.79

Source: Standard & Poors CreditWeek (April 15, 1996)

 Specify the spread curve
Category Year 1 Year 2 Year 3 Year 4
AAA 3.60 4.17 4.73 5.12
AA 3.65 4.22 4.78 5.17
A 3.72 4.32 4.93 5.32
BBB 4.10 4.67 5.25 5.63
BB 5.55 6.02 6.78 7.27
B 6.05 7.02 8.03 8.52
CCC 15.05 15.02 14.03 13.52

One year forward zero curves for each credit rating (%)
 forward
rate

CCC

Treasuries

time

Spread of high (low) investment grade bonds increases (decreases)

with maturity.
 Specify the forward pricing model

0 1 2 3 4 5 Time

6 6 6 6 106
Cash flows
(Forward price = 107.55)
VBBB

One-year forward price of the BBB bond

6 6 6 106
VBBB = 6 + + 2
+ 3
+ 4
= 107.55
1.041 (1.0467) (1.0525) (1.0563)
One-year forward values for a BBB bond
Year-end rating Value ($)
AAA 109.37
AA 109.19
A 108.66
BBB 107.55
BB 102.02
B 98.10
CCC 83.64
Default 51.13
Source: CreditMetrics, J. P. Morgan
 Specify the recovery rate
Seniority Class Mean (%) Standard Deviation (%)
Senior Secured 53.80 26.86
Senior Unsecured 51.13 25.45
Senior subordinated 38.52 23.81
Subordinated 32.74 20.18
Junior subordinated 17.09 10.90
Source: Carty & Lieberman [1996]

Recovery rates by seniority class (% of face value, i.e., par)

 Derive the forward distribution of the changes
in bond value
Year-end Probability Forward Change in
rating of state: price: V ($) value: V
p (%) ($)
AAA 0.02 109.37 1.82
AA 0.33 109.19 1.64
A 5.95 108.66 1.11
BBB 86.93 107.55 0
BB 5.30 102.02 -5.53
B 1.17 98.10 -9.45
CCC 0.12 83.64 -23.91
Default 0.18 51.13 -56.42
Source: CreditMetrics, J. P. Morgan

Distribution of the bond values, and changes in value of a BBB bond,

in one year. Note the long downside tail.
 Histogram of the one-year forward prices
and changes in value of a BBB bond

First percentile of V = 23.91

(credit VaR at the 99% confidence level)
Mean (V ) = m = pi Vi = 0.46
i

Variance (V ) = 2 = pi (Vi mean) = 8.95

i

First percentile of a normal distribution = m 2.33 = 7.43.

(Recall that 98% of observations lie between 2.33 and 2.33

from the mean for normal distributions.)
 Joint migration probabilities (%) with zero correlation
for 2 issuers rated BB and A

Obligor #2 (single-A)
Obligor #1 AAA AA A BBB BB B CCC Default
(BB) 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06
AAA 0.03 0.00 0.00 0.03 0.00 0.00 0.00 0.00 0.00
AA 0.14 0.00 0.00 0.13 0.01 0.00 0.00 0.00 0.00
A 0.67 0.00 0.02 0.61 0.40 0.00 0.00 0.00 0.00
BBB 7.73 0.01 0.28 7.04 0.43 0.06 0.02 0.00 0.00
BB 80.53 0.07 1.83 73.32 4.45 0.60 0.20 0.01 0.05
B 8.84 0.01 0.02 8.05 0.49 0.07 0.02 0.00 0.00
CCC 1.00 0.00 0.02 0.91 0.06 0.01 0.00 0.00 0.00
Default 1.06 0.00 0.02 0.97 0.06 0.01 0.00 0.00 0.00

Assuming zero correlation, each entry is given by the product of the

transition probabilities for each obligor. For example,

73.32% = 80.53% 91.05%

 Correlations between changes in credit quality
Correlations are expected to be higher for firms within the same
industry or in the same region.

Correlations vary with the relative state of the economy in the

business cycle. Eg. when the economy is performing well, default
correlations go down.

Default and migration probabilities should not stay stationary over

time.

Contrary to KMV, CreditMetrics have chosen the equity price as a

Proxy for the asset value of the firm that is not directly observed
a very strong assumption that may greatly affect the accuracy.
Derive the credit quality thresholds for each credit rating
 We slice the distribution of asset returns into bands in such a way
that if we draw randomly from this distribution, we reproduce
exactly the migration frequencies shown in the transition matrix.

Zccc is the threshold point to trigger default; Zccc is the

distance-to-default.

CreditMetrics estimates the correlations between the equity returns

of various obligors, then the model infers the correlations between
changes in credit quality directly from the joint distribution of
equality returns. The use of equity returns as a proxy is based on
the assumption that firms activities are all equity financed.
 Calculation of the joint rating probabilities

Pr( 1.23 < rBB < 1.37,1.51 < rA < 1.98) =

1.37 1.98
f ( rBB , rA ; )drBB drA = .7365
1.23 1.51

Rating of second company (A)

Rating
of first
company AAA AA A BBB BB B CCC Def Total
(BB)
AAA 0.00 0.00 0.03 0.00 0.00 0.00 0.00 0.00 0.03
AA 0.00 0.01 0.13 0.00 0.00 0.00 0.00 0.00 0.14
A 0.00 0.04 0.61 0.01 0.00 0.00 0.00 0.00 0.67
BBB 0.02 0.35 7.10 0.20 0.02 0.01 0.00 0.00 7.73
BB 0.07 1.79 73.65 4.24 0.56 0.18 0.01 0.04 80.53
B 0.00 0.08 7.80 0.79 0.13 0.05 0.00 0.01 8.84
CCC 0.00 0.01 0.85 0.11 0.02 0.01 0.00 0.00 1.00
Def 0.00 0.01 0.90 0.13 0.02 0.01 0.00 0.00 1.06
Total 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06 100

Joint rating probabilities (%) for BB and A rated obligors when

correlation between asset returns is 20%.
 Probability of joint defaults
P( DEF 1, DEF 2) P1 P 2
corr ( DEF 1, DEF 2) =
P1(1 P1) P 2(1 P 2)
[ ]
P ( DEF 1, DEF 2) = Pr r1 d 21 , r2 d 22 = N 2 (d 21 , d 22 ; )

Probability of joint defaults as a function of asset return correlation

 Sample calculation
Take = 20%,

P ( DEF1 , DEF2 ) = N 2 (d 21 ,d 22 ; ) = N 2 (3.24,2.30;0.20) = 0.000054.

P1 = 0.06% and P2 = 1.06%; so

corr ( DEF1 , DEF2 ) = 0.019 = 1.9%.

 Credit diversification
Implement a Monte Carlo simulation to generate the full distribution of
the portfolio values:

1. Derivation of the asset return thresholds for each rating categories.

2. Estimation of the correlation between each pair of obligors asset

returns.

3. Generation of asset return scenarios according to their joint normal

distribution (using the Cholesky decomposition). Each scenario is
characterized by n standardized asset returns, one for each obligor.

4. Given the spread curves which apply for each rating, the portfolio
is revalued.

5. Repeat the procedure a large number of times and plot the distribution
of the portfolio values.
 Credit-VaR and calculation of
economic capital
Economic capital stands as a cushion to absorb unexpected losses related
to credit events.

V(p) = value of the portfolio in the worst case scenario at the p%

confidence level
FV = forward value of the portfolio = V0(1 + PR)
where PR = promised return on the portfolio
EV = expected value of the portfolio = V0(1 + ER)
where ER = expected return on the portfolio
EL = expected loss = FV EV

Capital = EV V(p)
One may query the following assumptions in CreditMetrics

1. Firms within the same rating class are assumed to have the same
default rate.

2. The actual default rate (migration probabilities) are set equal to the
historical default rate (migration frequencies).

Default is only defined in a statistical sense (non-firm specific)

without explicit reference to the process which leads to default.
 Some other credit risk models
attempt to make improvements on
Defaults rates vary with current economic and financial
conditions of the firm.

Default rates change continuously (ratings are adjusted in

a discrete fashion).

Microeconomic approach to default: a firm is in default

when it cannot meet its financial obligations.
 Empirical studies show:

Historical average default rate and transition probabilities

can deviate significantly from the actual rates.

Substantial differences in default rates may exist within

the same bond rating class.

Overlapping in default probability ranges may be quite

large.